US Mutual Fund Flows Improve

US mutual fund flows have begun to recover. This is good for markets but fund managers may not deserve the new flows.

For most of 2010, retail investors had been hanging back from equity markets still shocked from their experiences of the previous two years. Even as conditions seemed to improve in early 2010, investors were again stunned by the prospect of defaulting European banks (and their host countries) precipitating another recession. There were few opportunities for confidence to regather.

As we enter 2011, we are seeing some signs of a thaw in the retail investment freeze which so dominated 2010. The first issue of the ATC Digest for 2011 highlights a set of numbers from the US Investment Company Institute (ICI) and their link to a possible continuation of a U.S. equity market recovery. The article includes some charts to illustrate the history referred to below.

According to the ICI, equity mutual funds were boosted by $5.1 billion in net new cash flows in December 2010. The last month has been noticeably stronger than the previous five months in which there was a total outflow of funds from all mutual fund equity products of $67.7 billion.

Going back to 1984, there have been net outflows of funds from US equity mutual funds in only five years. All but two of these negative occurrences were in the past three years and associated with the market collapse in 2008.

The strongest phases in US equity market conditions in the last 20 years coincided with the strongest flow of funds into equity mutual funds.

Unfortunately, outflows from domestic equity funds ($6.8 billion) continued in December althought th pace of withdrawals has diminished. Since the beginning of 2007, a positive net flow of funds into US domestic equity mutual funds has occurred in only 15 out of 48 months and the last monthly positive flow was last April.

The ICI numbers highlight the dominant sentiment within the US investment community that emerging and other foreign markets will perform better than the domestic US market in the year ahead.

While the tenor of the ATC Digest article is positive insofar as it links market conditions to a stronger flow of funds from retail investors, the article goes on to also highlight a sobering piece of research published in the Journal of Finance questioning why anyone would invest in a U.S. mutual fund in any event.

One of the conclusions of the research ("False Discoveries in Mutual Fund Performance:Measuring Luck in Estimated Alphas" by Laurent Barras, Olivier Scaillet, and Russ Wermers) is that the skill displayed by fund managers had been deteriorating for over a decade by the time of the global credit crisis. The researchers drew a distinction between skill and luck. When managers were beating the market, it was increasingly through luck and not skill to such an extent that, by 2006, almost no skillful funds existed.

The authors pondered, without conclusion, why investors had not tumbled to what was happening to the value of their investments. However, if the industry was so bereft of skill and investors were catching on, we may never see a return to the money flows which typified the earlier years of the 2000s.

One implication of the paper is to turn the apparent weakness in mutual fund flows on its head. The question should not be why flows have been so weak. Rather, we should be seeking an explanation for why they had been so irrationally strong!

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